Is the Fannie-Freddie debacle the result of a backroom deal?

Everyone should recall that Fannie Mae and Freddie Mac were forced to massively increase their already bloated balance sheet in the aftermath of the Bear Stearns collapse. It seems reasonable to me to assume that the two organizations did so only because they were given an implicit guarantee at the time by the government officials involved. Here is my train of thought.

In March, the Federal Government offered up this plan: If the GSEs offered (were coerced) to buy up massive amounts of mortgages even though it would bankrupt them, the Federal Government promised to nationalize the two companies, effectively guaranteeing all of the debt issued by the two and solving a nightmare problem.

Later, when the mortgages they owned had to be written down by hundreds of billions or trillions of dollars, it wouldn’t matter because the mortgages would be government-owned. The Treasury would simply issue more debt and the taxpayers would absorb these losses.

How it happenedIn early March the markets were in such turmoil that the global monetary authorities were forced to inject massive liquidity into the market.

The U.S. Federal Reserve, the European Central Bank and central banks in the UK, Canada and Switzerland will inject billions of dollars into money markets.

The news cheered investors and U.S. stocks surged more than 3% – their biggest one-day gain in five years.

The injection of more than $200bn is aimed at easing the credit crunch and its impact on the wider economy.–BBC News, 11 Mar 2008

One of the problems creating the panic on Wall Street was Bear Stearns. Rumours were going around that Bear had liquidity problems. The money injections by the central banks were an attempt to dampen the volatility. Nevertheless, the rumours about Bear Stearns’ viability ultimately brought the investment bank down.

On Monday, March 10, the rumor started: Bear Stearns was having liquidity problems. In fact, the maverick investment bank had around $18 billion in cash reserves. But soon the speculation created its own reality, and the race was on to keep Bear’s crisis from ravaging Wall Street. With the blow-by-blow from insiders, Bryan Burrough follows the players—Bear’s stunned executives, trigger-happy reporters at CNBC, a nervous Fed, a shadowy group of short-sellers—in what some believe was the greatest financial scandal in history.–Vanity Fair, August 2008

JP Morgan Chase was quickly brought in as a saviour and a deal was done and announced by the 14th.

Bear Stearns, facing a grave liquidity crisis, reached out to JPMorgan on Friday for a short-term financial lifeline and now faces the prospect of the end of its 85-year run as an independent investment bank.

This is when the GSEs get involved. Out of nowhere, they announced that they had been given the authority to buy massive amounts more of mortgage paper — the same junky paper, I might add, that had already caused nearly $200 billion in credit losses.

The Office of Federal Housing Enterprise Oversight said it is reducing Fannie Mae’s and Freddie Mac’s capital-surplus requirement to 20% from 30% previously. The companies will be clear to invest the additional capital in mortgages and mortgage-backed securities.

The move is expected to add up to $200 billion of immediate liquidity to the market for mortgage-backed securities. Wednesday’s move by Ofheo, combined with other actions, should enable the two companies to buy or guarantee about $2 trillion in mortgages this year.

Ofheo is the federal regulator for the two companies. In response to accounting scandals at the two companies, Ofheo has been requiring that Fannie and Freddie hold 30% more capital than typically required.

“We believe they can play an even more positive role in providing the stability and liquidity the markets need right now,” said Ofheo Director James Lockhart in a statement.–MarketWatch, 19 Mar 2008

Huh? Wait a minute, I thought Freddie had just written down $2.4 billion in December and was forced to raise $6 billion to increase its shaky capital base. An how in the world does a company like Fannie Mae with nearly $900 billion in assets (many of them junk mortgages) on only $44 billion in capital as of December 31st 2007, purchase hundreds of billions more to add to its bloated balance sheet?

I’ll tell you how. A bailout guarantee.

Look. The markets were in free fall in March. Bear went under just like that — in the blink of an eye. Rumours were spreading that Lehman was next. The central banks had already added massive liquidity. This was very frightening.

I imagine there was panic in the Treasury and in the White House and in the Fed and at OFHEO. Something had to be done. And what I believe was done was a bailout.

Remember what the Wall Street Journal said yesterday?

The Bush administration has held talks about what to do in the event mortgage giants Fannie Mae and Freddie Mac falter, according to three people familiar with the matter, as the stock prices of both companies continue to fall sharply.These discussions have been going on for months and are part of normal contingency planning that the Treasury Department and other financial regulators regularly undertake. The talks have become more serious recently given the financial woes of the shareholder-owned, government-chartered companies, whose stability is vital to the functioning of the nation’s housing market, these people say.–WSJ, 10 Jul 2008

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.